Roger C. Gibson, the author of Asset Allocation: Balancing Financial Risk was recently interviewed by Morningstar Advisor to offer his perspective on the turbulent stock market of the last year. Gibson is an expert on portfolio construction and investment management. His observations are worth considering.

No Place to Hide in 2008

Morningstar’s data base includes approximately 4,000 mutual funds that invest in either stocks or real estate (U.S. or international). All but one had losses in 2008.

“Of 1,730 bond funds–both taxable and municipal–68% lost money, which surprised us. Those that didn’t were (U.S) government or short term bond funds.”

“I’ve never seen losses like 2008, but it wasn’t something completely unthinkable. And when you have absolutely horrible, panic-driven significant losses, they’re usually not just confined to a particular asset class. In 2008, panic fed on itself.”

Volatility

Gibson tabulated the number of days the Standard and Poor’s 500 gained or lost 5% or more. Between January 2008 and August 2008, there were no 5% days. Between September and December there were 18 days when the market moved 5% or more, or one out for five! This is unprecedented volatility.

It is quite amazing how investors have become accustomed to 5% fluctuations in a single day. According to Gibson, “Over the last 50 years, these kinds of moves probably only happened once a year and, already, investors have almost gotten numb to this volatility.”

What can we learn from 2008?

“During times of excessive optimism, people overshoot markets on the high side, and during times of extreme fear and panic, markets overshoot on the downside. In 2008, people panicked and dumped securities, which sets the stage for higher-than-normal rewards for people holding on.”

Regarding asset allocation and diversification, “Strategic asset allocation isn’t broken and never promised to sidestep a year like 2008, but what it will do is make the portfolio as a whole have less average risk. That’s mathematically driven. And it will cause a portfolio to have a higher compound return than the average return of its asset classes. That said, it doesn’t mean you can’t get into a scary environment.”

Conclusion

In previous posts, I have written about the futility of trying to predict the near term direction of the stock markets. It just can’t be done successfully on a continuous basis, neither by you, on your own, nor with the help of a market strategist. I’ve also written about the near impossibility of improving your overall results by pulling out of the market and waiting until you think it’s a better time to invest. Finally, I have outlined the evidence for the failure of market selection – finding underpriced securities.

Given what does not work, what is the recommended approach? In my opinion, it is a diversified, low cost, buy-and-hold portfolio matched to your time horizon and risk tolerance.

To be continued.

I loved this article, because I believe that Veres captures, so perfectly, the fear that is motivating, not just many inexperienced investors, but himself, as well. What’s interesting is that, while he has a very well developed and rational understanding of what investing in the stock market sometimes entails, he is still gripped by the fear of the “roller coaster ride” and the scary (but unrealistic) feeling that we are about to fall into the abyss.

Even though he knows better, he still can’t help the way he feels, because of what he refers to as “the lizard-like part of the back of (the) brain” which screams “against all logic and against many things I (know) to be true.”

If you are extremely fearful and cannot possibly imagine that there is a bottom to the stock market, give yourself a little understanding and possibly a little more TLC. You are not alone; in fact, you are in good company.

I recommend that you read the whole article, but here is the conclusion.

I’m one of those financial media types, and also a pundit on occasion, and I can tell you that I can hear the lizard’s scream echoing across the financial landscape, so loudly that it’s hard to remember that stocks are on a fire sale now and they are certainly a hell of a lot less risky than they were last August, and that these rides are seldom fatal to those who stay in their seats, and they are usually at least harmful to those who panic, unhook their seatbelts and jump over the side toward the distant anthill below.

I can hardly wait to look back on those charts and wonder what the hell we were thinking getting so panicky about a blip, and I know at that time that the lizard will be giving me a different message: that if only I’d had the sense to buy when everybody else was selling…

This too shall pass, and 99% of your brain knows it. The market belongs to the lizard now, and I am ashamed to admit that I, the pundit, the media guru, still feel that sense of panic on the way down, irrational as I know it is. I feel it so much that sometimes I can barely hear the rational part of my mind over the screaming that echoes that are calling up from a deeper part of my consciousness. I would curse the designer of this roller coaster, as I did the fiend who put that damn thing up at Sea World, but I’m afraid this time it is us, collectively, who designed our own fear machine.

As stock prices have declined this week, I have noticed some sloppy journalism. According to newspapers and TV programs, there is so much pessimism about the economy that no one is buying stocks. Clearly if everyone else is selling, you would be foolish to be a buyer.

To get a sense of this interpretation, take a look at today’s New York Times article Slump Humbling Blue-Chip Stocks, Once Dow’s Pride by Jack Healy.

Here are some relevant quotes with my comments:

“With so much uncertainty, investors are parachuting out of companies like banks, retailers and utilities, and abandoning stock markets everywhere from Asia to Europe to Wall Street.” (Parachuting? Nice metaphor.)

“No one is taking a back-seat approach. Everyone is just selling.” – Peter I. Cardillo, chief market economist at Avalon Partners.  (Everyone?)

“Nobody wants to be invested, that’s the problem. I don’t believe we’re at the bottom yet.” – Eric Ross, director of research at the brokerage firm Canaccord Adams. (Nobody?)

A similar story was portrayed in an article in the Wall Street Journal, Stocks Hit ‘97 Level, Signaling Long Slump, on March 3, 2009 by Tom Lauricella and Annelena Lobb.

Here are a few quotes with my comments.

“It’s like an unending nightmare” – Kent Engelke, managing director at Capital Securities Management . (This is an exaggeration and seems to suggest prices will continue to drop.)

“The relentless decline is pushing investors to the sidelines.” (Not really. See explanation below.)

“I want to wait for a firm turnaround, and be as safe as possible,” Bijon Mishras, a financial-services consultant in New York. (Whoa, Nelly. Remember this quote and see how it turns out.)

“Nobody wants to buy a market today that they think is going to be down 2 or 3% tomorrow,” says Michael O’Rourke, chief market strategist at brokerage firm BTIG LLC. (Nobody?)

A Reality Check

Yes, the economic news coming out of everywhere is very bad, and yes, stock prices have had steep declines. But guess what? Every single time that someone sells a stock position, someone is on the other side of that transaction. Every single time. What do we call such a person? Insane? No. How about “buyer.” Sellers and buyers must be equal!

For every person who sells because he or she doesn’t like the prospects for the future (a.k.a a “pessimist”), there is someone who is buying (a.k.a. an “optimist”). That person thinks the investment is at a great price. Those two groups of investors or participants in the market have to be in equilibrium at all times.

When you look at it from that perspective, you don’t get the overwhelming sense of doom that the media creates — that there’s only one way for prices to go, and that is down. If that really is the case, then there are a lot of crazy people who are buying now.  I don’t think so.

The fact that prices have been going down does not mean that they will continue to go down. Just as in 1999, the fact that prices had been going up did not mean that it was a good time to buy stocks.

Risk/Reward

No one knows what tomorrow will bring, but unless capitalism ceases to function, stockholders will be rewarded in the long term for owning stocks and for taking risks. Yes, there is risk in owning stocks, as we have recently experienced. Since we’ve already seen the risk, how about staying around for the reward?

An old Wall Street proverb is that “Nobody rings a bell at the top or the bottom of a market.”

Are you waiting for that bell to ring? Don’t.

When a bubble occurs, Wall Street executives may reinforce it through rational self-interest. The previous post included this quote from Henry Blodget:

“In the money-management business, therefore, investment risk is the risk that your bets will cost your clients money. Career or business risk, meanwhile, is the risk that your bets will cost you or your firm money or clients.”

Blodget expands on this notion.

This tension between investment risk and career or business risk comes into play in other areas of Wall Street too. It was at the center of the decisions made in the past few years by half a dozen seemingly brilliant CEOs whose firms no longer exist.

Why did Bear Stearns, Lehman Brothers, Fannie Mae, Freddie Mac, AIG, and the rest of an ever-growing Wall Street hall of shame take so much risk that they ended up blowing their firms to kingdom come? Because in a bull market, when you borrow and bet $30 for every $1 you have in capital, as many firms did, you can do mind-bogglingly well. And when your competitors are betting the same $30 for every $1, and your shareholders are demanding that you do better, and your bonus is tied to how much money your firm makes—not over the long term, but this year, before December 31—the downside to refusing to ride the bull market comes into sharp relief. And when naysayers have been so wrong for so long, and your risk-management people assure you that you’re in good shape unless we have another Great Depression (which we won’t, of course, because it’s different this time), well, you can easily convince yourself that disaster is a possibility so remote that it’s not even worth thinking about.

It’s easy to lay the destruction of Wall Street at the feet of the CEOs and directors, and the bulk of the responsibility does lie with them. But some of it lies with shareholders and the whole model of public ownership. Wall Street never has been—and likely never will be—paid primarily for capital preservation. However, in the days when Wall Street firms were funded primarily by capital contributed by individual partners, preserving that capital in the long run was understandably a higher priority than it is today. Now Wall Street firms are primarily owned not by partners with personal capital at risk but by demanding institutional shareholders examining short-term results. When your fiduciary duty is to manage the firm for the benefit of your shareholders, you can easily persuade yourself that you’re just balancing risk and reward—when what you’re really doing is betting the firm.

As we work our way through the wreckage of this latest colossal bust, our government—at our urging—will go to great lengths to try to make sure such a bust never happens again. We will “fix” the “problems” that we decide caused the debacle; we will create new regulatory requirements and systems; we will throw a lot of people in jail. We will do whatever we must to assure ourselves that it will be different next time. And as long as the searing memory of this disaster is fresh in the public mind, it will be different. But as the bust recedes into the past, our priorities will slowly change, and we will begin to set ourselves up for the next great boom.

A few decades hence, when the Great Crash of 2008 is a distant memory and the economy is humming along again, our government—at our urging—will begin to weaken many of the regulatory requirements and systems we put in place now. Why? To make our economy more competitive and to unleash the power of our free-market system. We will tell ourselves it’s different, and in many ways, it will be. But the cycle will start all over again.

What can we learn from this bubble?

First, bubbles are to free-market capitalism as hurricanes are to weather: regular, natural, and unavoidable. They have happened since the dawn of economic history, and they’ll keep happening for as long as humans walk the Earth, no matter how we try to stop them. We can’t legislate away the business cycle, just as we can’t eliminate the self-interest that makes the whole capitalist system work. We would do ourselves a favor if we stopped pretending we can.

Second, bubbles and their aftermaths aren’t all bad: the tech and Internet bubble, for example, helped fund the development of a global medium that will eventually be as central to society as electricity. Likewise, the latest bust will almost certainly lead to a smaller, poorer financial industry, meaning that many talented workers will go instead into other careers—that’s probably a healthy rebalancing for the economy as a whole. The current bust will also lead to at least some regulatory improvements that endure; the carnage of 1933, for example, gave rise to many of our securities laws and to the SEC, without which this bust would have been worse.

Lastly, we who have had the misfortune of learning firsthand from this experience—and in a bust this big, that group includes just about everyone—can take pains to make sure that we, personally, never make similar mistakes again. Specifically, we can save more, spend less, diversify our investments, and avoid buying things we can’t afford. Most of all, a few decades down the road, we can raise an eyebrow when our children explain that we really should get in on the new new new thing because, yes, it’s different this time.

Conclusion

A number of things must come together to cause a bubble. One of them is an ignorance of history. We forget that markets can be cyclical. During the boom years, many of us conveniently forget (or didn’t even consider) the possibility of a bust.

It typically takes 30 years for a new group of potential believers to arrive.  Inexperienced investors make it possible for price increases (success) to lead to more price increases (excess).

The old adage, “What goes up must come down” is overwhelmed by “it’s different this time.”

Don’t expect your typical Wall Street messenger to warn you about the danger. Wall Street executives are typically concerned about career risk.  Moreover, in the last bubble, they did a very bad job of managing risk for their own firms.

Why Wall Street Always Blows It  by Henry Blodget appeared in the December issue of The Atlantic. The article offers interesting observations on how powerful incentives have compelled Wall Street executives to play musical chairs with their clients’ money, until the music finally stopped.

Here’s what Blodget has to say (emphasis added).

But most bubbles are the product of more than just bad faith, or incompetence, or rank stupidity; the interaction of human psychology with a market economy practically ensures that they will form. In this sense, bubbles are perfectly rational—or at least they’re a rational and unavoidable by-product of capitalism (which, as Winston Churchill might have said, is the worst economic system on the planet except for all the others). Technology and circumstances change, but the human animal doesn’t. And markets are ultimately about people.

Everyone …bears some responsibility too. But … it would be hard to say that any of them acted criminally. Or irrationally. Or even irresponsibly. In fact, almost everyone …acted just the way you would expect them to act under the circumstances.

That’s especially true for the professionals on Wall Street, who’ve come in for more criticism than anyone in recent months, and understandably so. It was Wall Street, after all, that chose not only to feed the housing bubble, but ultimately to bet so heavily on it as to put the entire financial system at risk. How did the experts who are paid to obsess about the direction of the market—allegedly the most financially sophisticated among us—get it so badly wrong? The answer is that the typical financial professional is a lot more like our hypothetical home buyer than anyone on Wall Street would care to admit. Given the intersection of experience, uncertainty, and self-interest within the finance industry, it should be no surprise that Wall Street blew it—or that it will do so again.

Since Wall Street replenishes itself with a new crop of fresh faces every year—many of the professionals at the elite firms either flame out or retire by age 40—most of the industry doesn’t usually have experience with both booms and busts. In the 1990s, I and thousands of young Wall Street analysts and investors like me hadn’t seen anything but a 15-year bull market. The only market shocks that we knew much about—the 1987 crash, say, or Mexico’s 1994 financial crisis—had immediately been followed by strong recoveries (and exhortations to “buy the dip”).

By 1996, when Greenspan made his famous “irrational exuberance” remark, the stock market’s valuation was nearing its peak from prior bull markets, making some veteran investors nervous. Over the next few years, however, despite confident predictions of doom, stocks just kept going up. And eventually, inevitably, this led to assertions that no peak was in sight, much less a crash—you see, it was “different this time.”

Those are said to be the most expensive words in the English language, by the way: it’s different this time. You can’t have a bubble without good explanations for why it’s different this time. If everyone knew that this time wasn’t different, the market would stop going up. But the future is always uncertain—and amid uncertainty, all sorts of faith-based theories can flourish, even on Wall Street.

In the 1920s, the “differences” were said to be the miraculous new technologies (phones, cars, planes) that would speed the economy, as well as Prohibition, which was supposed to produce an ultra-efficient, ultra-responsible workforce. (Don’t laugh: one of the most respected economists of the era, Irving Fisher of Yale University, believed that one.) In the tech bubble of the 1990s, the differences were low interest rates, low inflation, a government budget surplus, the Internet revolution, and a Federal Reserve chairman apparently so divinely talented that he had made the business cycle obsolete. In the housing bubble, they were low interest rates, population growth, new mortgage products, a new ownership society, and, of course, the fact that “they aren’t making any more land.”

In hindsight, it’s obvious that all these differences were bogus (they’ve never made any more land—except in Dubai, which now has its own problems). At the time, however, with prices going up every day, things sure seemed different.

In fairness to the thousands of experts who’ve snookered themselves throughout the years, a complicating factor is always at work: the ever-present possibility that it really might have been different. Everything is obvious only after the crash.

Of course, as …was crystal clear to most Wall Street executives at the time—being bullish in a bull market is undeniably good for business. When the market is rising, no one wants to work with a bear.

Which brings us to the last major contributor to booms and busts: self-interest.

When people look back on bubbles, many conclude that the participants must have gone stark raving mad. In most cases, nothing could be further from the truth.

This does not make the participants villains or morons. It does, however, illustrate another critical component of boom-time decision-making: the difference between investment risk and career or business risk.

Professional fund managers are paid to manage money for their clients. Most managers succeed or fail based not on how much money they make or lose but on how much they make or lose relative to the market and other fund managers.

If the market goes up 20 percent and your Fidelity fund goes up only 10 percent, for example, you probably won’t call Fidelity and say, “Thank you.” Instead, you’ll probably call and say, “What am I paying you people for, anyway?” (Or at least that’s what a lot of investors do.) And if this performance continues for a while, you might eventually fire Fidelity and hire a new fund manager.

On the other hand, if your Fidelity fund declines in value but the market drops even more, you’ll probably stick with the fund for a while (“Hey, at least I didn’t lose as much as all those suckers in index funds”). That is, until the market drops so much that you can’t take it anymore and you sell everything, which is what a lot of people did in October, when the Dow plunged below 9,000.

In the money-management business, therefore, investment risk is the risk that your bets will cost your clients money. Career or business risk, meanwhile, is the risk that your bets will cost you or your firm money or clients.

The tension between investment risk and business risk often leads fund managers to make decisions that, to outsiders, seem bizarre. From the fund managers’ perspective, however, they’re perfectly rational.

In the late 1990s, while I was trying to figure out whether it was different this time, some of the most legendary fund managers in the industry were struggling. Since 1995, any fund managers who had been bearish had not been viewed as “wise” or “prudent”; they had been viewed as “wrong.” And because being wrong meant underperforming, many had been shown the door.

It doesn’t take very many of these firings to wake other financial professionals up to the fact that being bearish and wrong is at least as risky as being bullish and wrong. The ultimate judge of who is “right” and “wrong” on Wall Street, moreover, is the market, which posts its verdict day after day, month after month, year after year. So over time, in a long bull market, most of the bears get weeded out, through either attrition or capitulation.

By mid-1999, with mountains of money being made in tech stocks, fund owners were more impatient than ever: their friends were getting rich in Cisco, so their fund manager had better own Cisco—or he or she was an idiot. And if the fund manager thought Cisco was overvalued and was eventually going to crash? Well, in those years, fund managers usually approached this type of problem in of one of three ways: they refused to play; they played and tried to win; or they split the difference.

Conclusion

When stocks (or house prices) are going up, it is very easy to be optimistic or at least go along with the crowd. There are always many reasons to explain why “the sky is the limit.” That’s how the phrase “it’s different this time” gains currency.

If you work on Wall Street, it’s bad business to be prematurely negative, because you may miss out on the “easy money.” And it can be bad for your career to be pessimistic or even doubtful of the new paradigm.

“Everyone was doing it” may not be a defense for a child’s behavior, but it seems to apply to investment managers who are willing to take on additional risk to attempt outperformance.

Instead of reining in over-optimism and greed, Wall Street executives became enablers for their clients. The timing could not have been worse.

Note that a conservative diversified portfolio will underperform in a bubble but will typically avoid a steep decline when the market turns. This approach is not perfect, but it sure beats chasing performance when everyone says, “this time it’s different.”

To be continued …

In my previous post, I started with Henry Blodget’s belief that we are all to be blamed for the housing boom and bust.

It was purely greed, or to put it more kindly, as we shall read – self interest.

Here’s where we left off:

How on Earth did we get into this mess?

The exact answer is different in every case, of course. But let’s round up the usual suspects:

• The predatory mortgage broker? Well, we’re certainly not happy with the bastard, given that he sold us a loan that is now a ticking time bomb. But we did ask him to show us a range of options, and he didn’t make us pick this one. We picked it because it had the lowest payment.

• Our sleazy real-estate agent? We’re not speaking to her anymore, either (and we’re secretly stoked that her BMW just got repossessed), but again, she didn’t lie to us. She just kept saying that houses are usually a good investment. And she is, after all, a saleswoman; that was never very hard to figure out.

• Wall Street fat cats? Boy, do we hate those guys, especially now that our tax dollars are bailing them out. But we didn’t complain when our lender asked for such a small down payment without bothering to check how much money we made. At the time, we thought that was pretty great.

• The SEC? We’re furious that our government let this happen to us, and we’re sure someone is to blame. We’re not really sure who that someone is, though. Whoever is responsible for making sure that something like this never happens to us, we guess.

• Alan “The Maestro” Greenspan? We’re pissed at him too. If he hadn’t been out there saying everything was fine, we might have believed that economist who said it wasn’t.

• Bad advice? Hell, yes, we got bad advice. Our real-estate agent. That mortgage guy. Our neighbor. Greenspan. The media. They all gave us horrendous advice. We should have just waited for the market to crash. But everyone said it was different this time.

Still, except in cases involving outright fraud—a small minority—the buck stops with us. Not knowing that the market would crash isn’t an excuse. No one knew the market would crash, even the analysts who predicted that it would. (Just as important, no one knew when prices would go down, or how fast.) And for years, most of the skeptics looked—and felt—like fools.

Everyone else on that list above bears some responsibility too. But in the case I have described, it would be hard to say that any of them acted criminally. Or irrationally. Or even irresponsibly. In fact, almost everyone on that list acted just the way you would expect them to act under the circumstances.

The most expensive words in the English language, by the way: it’s different this time. You can’t have a bubble without good explanations for why it’s different this time. If everyone knew that this time wasn’t different, the market would stop going up. But the future is always uncertain—and amid uncertainty, all sorts of faith-based theories can flourish, even on Wall Street.

In the tech bubble of the 1990s, the differences were low interest rates, low inflation, a government budget surplus, the Internet revolution, and a Federal Reserve chairman apparently so divinely talented that he had made the business cycle obsolete. In the housing bubble, they were low interest rates, population growth, new mortgage products, a new ownership society, and, of course, the fact that “they aren’t making any more land.”

In hindsight, it’s obvious that all these differences were bogus (they’ve never made any more land—except in Dubai, which now has its own problems). At the time, however, with prices going up every day, things sure seemed different.

In fairness to the thousands of experts who’ve snookered themselves throughout the years, a complicating factor is always at work: the ever-present possibility that it really might have been different. Everything is obvious only after the crash.

Which brings us to the last major contributor to booms and busts: self-interest.

When people look back on bubbles, many conclude that the participants must have gone stark raving mad. In most cases, nothing could be further from the truth.

In my example from the housing boom, for instance, each participant’s job was not to predict what the housing market would do but to accomplish a more concrete aim. The buyer wanted to buy a house; the real-estate agent wanted to earn a commission; the mortgage broker wanted to sell a loan; Wall Street wanted to buy loans so it could package and resell them as “mortgage-backed securities”; Alan Greenspan wanted to keep American prosperity alive; members of Congress wanted to get reelected. None of these participants, it is important to note, was paid to predict the likely future movements of the housing market. In every case (except, perhaps, the buyer’s), that was, at best, a minor concern.

Conclusion

When everyone is under the (mis)conception that housing prices can move in only one direction, namely up, it’s not unexpected that people react in a way that seems perfectly rational. Of course, it is only later that we see the folly of that reaction.  Indeed, the most expensive words in the English language are “it’s different this time.”

Next up: How Wall Street was swept along in the “bubble” mentality and how incentives shaped the behavior of its executives.

photo credit: laurgasms

In the December issue of The Atlantic, Why Wall Street Always Blows It  by Henry Blodget provides a thought provoking view on what went wrong with the housing market. Blodget has two simple arguments to underscore what went wrong: (1) We are all to be blamed, and (2) Wall Street had powerful incentives which compelled it to keep playing musical chairs until the music eventually stopped.

How are we all to blame? According to Blodget, in a word: Greed.

Here’s what Blodget has to say on that point.

Well, we did it again. Only eight years after the last big financial boom ended in disaster, we’re now in the migraine hangover of an even bigger one—a global housing and debt bubble whose bursting has wiped out tens of trillions of dollars of wealth and brought the world to the edge of a second Great Depression.

Millions have lost their houses. Millions more have lost their retirement savings. Tens of millions have had their portfolios smashed. And the carnage in the “real economy” has only just begun.

What the hell happened? After decades of increasing financial sophistication, weren’t we supposed to be done with these things? Weren’t we supposed to know better?

Yes, of course. Every time this happens, we think it will be the last time. But it never will be.

I experienced the (housing) bubble differently—as a journalist and homeowner. Having already learned the most obvious lesson about bubbles, which is that you don’t want to get out too late, I now discovered something nearly as obvious: you don’t want to get out too early. Figuring that the roaring housing market was just another tech-stock bubble in the making, I rushed to sell my house in 2003—only to watch its price nearly double over the next three years. I also predicted the demise of the Manhattan real-estate market on the cover of New York magazine in 2005. Prices are finally falling now, in 2008, but they’re still well above where they were then.

Live through enough bubbles, though, and you do eventually learn something of value. For example, I’ve learned that although getting out too early hurts, it hurts less than getting out too late. More important, I’ve learned that most of the common wisdom about financial bubbles is wrong.

Who’s to blame for the current crisis? As usually happens after a crash, the search for scapegoats has been intense, and many contenders have emerged: Wall Street swindled us; predatory lenders sold us loans we couldn’t afford; the Securities and Exchange Commission fell asleep at the switch; Alan Greenspan kept interest rates low for too long; short-sellers spread negative rumors; “experts” gave us bad advice. More-introspective folks will add other explanations: we got greedy; we went nuts; we heard what we wanted to hear.

All of these explanations have some truth to them. Predatory lenders did bamboozle some people into loans and houses they couldn’t afford. The SEC and other regulators did miss opportunities to curb some of the more egregious behavior. Alan Greenspan did keep interest rates too low for too long (and if you’re looking for the single biggest cause of the housing bubble, this is it). Some short-sellers did spread negative rumors. And, Lord knows, many of us got greedy, checked our brains at the door, and heard what we wanted to hear.

But most bubbles are the product of more than just bad faith, or incompetence, or rank stupidity; the interaction of human psychology with a market economy practically ensures that they will form. In this sense, bubbles are perfectly rational—or at least they’re a rational and unavoidable by-product of capitalism (which, as Winston Churchill might have said, is the worst economic system on the planet except for all the others). Technology and circumstances change, but the human animal doesn’t. And markets are ultimately about people.

House prices, we are told by our helpful neighborhood real-estate agent, almost never go down. This sounds right, and they certainly didn’t go down in the stock-market crash. In fact, for as long as we can remember—about 10 years, in most cases—house prices haven’t gone down. (Wait, maybe there was a slight dip, after the 1987 stock-market crash, but looming larger in our memories is what’s happened since; everyone we know who’s bought a house since the early 1990s has made gobs of money.)

We consider following our agent’s advice, but then we decide against it. House prices have doubled since the mid-1990s; we’re not going to get burned again by buying at the top. So we decide to just stay in our rent-stabilized rabbit warren and wait for house prices to collapse.

Unfortunately, they don’t. A year later, they’ve risen at least another 10 percent. By 2006, we’re walking past neighborhood houses that we could have bought for about half as much four years ago; we wave to happy new neighbors who are already deep in the money. One neighbor has “unlocked the value in his house” by taking out a cheap home-equity loan, and he’s using the proceeds to build a swimming pool. He is also doing well, along with two visionary friends, by buying and flipping other houses—so well, in fact, that he’s considering quitting his job and becoming a full-time real-estate developer. After four years of resistance, we finally concede—houses might be a good investment after all—and call our neighborhood real-estate agent. She’s jammed (and driving a new BMW), but she agrees to fit us in.

We see five houses: two were on the market two years ago for 30 percent less (we just can’t handle the pain of that); two are dumps; and the fifth, which we love, is listed at a positively ridiculous price. The agent tells us to hurry—if we don’t bid now, we’ll lose the house. But we’re still hesitant: last week, we read an article in which some economist was predicting a housing crash, and that made us nervous. (Our agent counters that Greenspan says the housing market’s in good shape, and he isn’t known as “The Maestro” for nothing.)

When we get home, we call our neighborhood mortgage broker, who gives us a surprisingly reasonable quote—with a surprisingly small down payment. It’s a new kind of loan, he says, called an adjustable-rate mortgage, which is the same kind our neighbor has. The payments will “reset” in three years, but, as the mortgage broker suggests, we’ll probably have moved up to a bigger house by then. We discuss the house during dinner and breakfast. We review our finances to make sure we can afford it. Then, the next afternoon, we call the agent to place a bid. And the house is already gone—at 10 percent above the asking price.

By the spring of 2007, we’ve finally caught up to the market reality, and our luck finally changes: We make an instant, aggressive bid on a huge house, with almost no money down. And we get it! We’re finally members of the ownership society.

You know the rest. Eighteen months later, our down payment has been wiped out and we owe more on the house than it’s worth. We’re still able to make the payments, but our mortgage rate is about to reset. And we’ve already heard rumors about coming layoffs at our jobs. How on Earth did we get into this mess?

To be continued …

photo credit: Joe Shlabotnik

“Something that everyone knows isn’t worth knowing.” – Bernard Baruch. 

Baruch was referring to individual stocks, but I take his meaning to include the economy and “the stock market” as a whole. If something is already known, it will have no further influence on individual stocks or the stock market. It is only something new that will affect prices.

Larry Swedroe is the co-author of The Only Guide to Alternative Investments You’ll Ever Need.

In a recent interview with HardAssetsInvestor.com, he talked about commodities, portfolio construction and investing strategy. He also related his outlook for the U.S. economy as a whole to his view on future returns in the stock market. Surprisingly, he is optimistic.

I know, firsthand, that a great many investors are discouraged and/or disgusted with the downturn in the economy, in general, and the decline in the markets, specifically, over the past months. Some investors have fled the stock market for safer investments. And, yes, I realize that it is difficult to find any silver lining in the current dark clouds of the economy.

Certainly, the volatility of the stock market cannot make anyone feel peaceful. It’s clear that optimism is in short supply.

Nevertheless, Swedroe thinks this may be a good time to invest in stocks. Please, consider his logic, which I personally find very persuasive.

HardAssetsInvestor.com: What are your general thoughts about the economy and the stock market here?

Swedroe: The big picture is simply this: Clearly, this is the worst economic crisis we’ve seen since the Great Depression. But wait … did I tell you anything you didn’t already know? The markets know that too. This is the worst market since the Great Depression.

We all know the economic news is going to get worse. Unemployment is going to go up; retail sales are going to go down. But while everyone’s focusing on the bad economic news, they’re forgetting that the market has already understood this.

People are saying, why can’t this be another Great Depression? And it could; you can’t rule that out. But what people fail to understand is this: In the Great Depression, the policy responses were all in the wrong direction. We raised taxes and raised interest rates, increased margin and reserve requirements, and started a trade war. The policy responses this time, whether you agree with them or not, have not only been in the right direction – cutting interest rates, flooding the markets with liquidity, etc. – but they have been the most massive effort ever.

The effort is coordinated around the globe, and countries are pledging to maintain free trade. Every major country is enacting fiscal stimulus programs, all the central banks are cutting interest rates, etc. So while we have had a massive economic crisis, offsetting that are the largest policy responses in history coordinated around the globe. Policy responses take a while to work through the system, while the economic news will continue to look bad for a while.

Remember: Just when things look darkest, stocks tend to have good returns. Prior to this year, when consumer confidence has fallen below 50, the average return for stocks the next year was 16%.

Or consider this: When the unemployment rate is below 4.3%, the average return to stocks is 2%. When the unemployment rate is over 6%, the average return to stocks is 15%.

In the 11 recessions in the post-war era, the cumulative return to stocks is up 7%, and T-bills are up 5%. Returns were positive and better than the risk-free rate. Every time an investor sold stocks and paid taxes, they would have been better off sitting pat in stocks. The only way to do better would have been to forecast the recession, and who can do that?

I cannot guarantee that we will get out of this crisis, but we have gotten out of every other crisis quite well.

(Emphasis added)

Conclusion

Certainly, there is no shortage of bad economic news: Home prices are falling, unemployment is rising, the stock market has had one of its worst years on record, and the automobile industry is asking the federal government for bailouts, like the financial services industry before them. Where will it all end? Is there any good news?

Indeed. Unfortunately, we do not know when the good news will arrive. But, what we do know is that whatever negative that can be said about the economy is already known. If it is widely known, then the bad news is already reflected in current stock prices.

If history has any relevance, and I think it does, after a stock market decline, when pessimism is commonplace, is a very good time to expect stocks to have higher returns.

This may be counterintuitive, but it is true, historically.

I tend to read market commentaries with a jaundiced eye. That’s because the authors generally restate the obvious, i.e. what has already happened, or they attempt to predict the future, which is simply impossible.

The Stock Market is Not in “Uncharted Territory,” the November 17th Market Commentary by John P. Hussman is an exception. Rather than make definitive predictions, he outlines his strategy by putting the stock market and the economy in historical perspective. Here are some quotes I like:

Investors can get a good understanding of market history by examining a great deal of data, or by living through a lot of market cycles and learning something along the way. Only investors who have done neither believe that current conditions are “uncharted territory.” Veterans like Warren Buffett and Jeremy Grantham have a good handle on both historical data, and on the concept that stocks are a claim to a very long-term stream of future cash flows. They recognize that even wiping out a year or two of earnings does no major damage to the intrinsic value of companies with good balance sheets and strong competitive positions.

Most importantly, these guys never changed their standards of value even when other investors were bubbling and gurgling about a new era of productivity where knowledge-based companies would make the business cycle obsolete, and where profit margins would never mean-revert. They knew to ignore the reckless optimism then, because they understood that stocks were claims on a very long-term stream of cash flows. They know to ignore the paralyzing fear now, because they still understand that stocks are a claim on a very long-term stream of cash flows.

No thoughtful investor “calls a bottom” in the markets. Stocks are undervalued here, but they could decline further. Economic conditions are poor, but may be over or under-reflected in stock prices. Investors will find out over time, and the ebb-and-flow of information is slow enough to allow very large market fluctuations in the meantime.

Recent market conditions seem like they have no precedent only because so many investment professionals know only the data they’ve lived through. If one actually examines market data from the Great Depression, 1907, and other less extreme panics, one realizes how much the recent decline has already discounted potential economic negatives. At this point, further declines in stock prices simply increase the long-term returns that investors can expect over time. We can’t rule out the possibility that investors could get more frightened, or that they might abandon their stocks at prices that would offer extremely high long-term returns to the buyers. It is important to establish exposure slowly, but long-term investors who ignore attractive valuations are not investors at all.

The main damage that investors can do to their financial security at this point would come from selling into steep but impermanent declines.

As a side note, do your best to filter out comments like “investors are moving out of stocks and into …” or “investors are selling into this decline” or “investors are buying into this rally.” On balance, investors do not sell shares, and they don’t buy shares. Every share purchased is a share sold. The only question is what price movement is required to prompt a buyer and a seller to trade with each other. No money will come off the sidelines into stocks. No money will come out of stocks and onto the sidelines. All such talk is non-equilibrium idiocy. Keep in mind that the “market” consists of different traders with a variety of time-horizons, risk-tolerances, and analytical methods (e.g. technical, report-driven, value-conscious). It is helpful to think in terms of which group of individuals is likely to do what, and when. It is equally important to know which group of investors you belong to. As the old saying goes, if you’re at a poker table and you don’t know who the patsy is, you’re the patsy.

Conclusion

No one knows or can accurately predict where stock prices are heading in the short term. It is true that if we have another Great Depression, stock prices will decline further. It is also true that after the steep decline (which we have already experienced, and which is not unprecedented) future returns are likely to be higher, not lower.

In the long term, investors are compensated for taking risks. Consequently, it is highly unlikely that, over the long term, safe investments will have higher returns than equities.

Timing the “market bottom” is impossible, but selling stocks now will most likely result in regrets later.

photo credit: erin MC hammer

“We cannot assume that even if the economic news gets worse that prices will decline further. It’s quite possible that prices are already reflecting investor concerns of more trouble ahead and may rise despite more gloomy business reports in days and months to come.” – Weston J. Wellington.
 
Today’s New York Times has two editorials, both of them well worth reading; one was written by Nobel prize-winning economist Paul Krugman and the other by Warren Buffett, the chairman and chief executive officer of Berkshire Hathaway, who is touted as one of history’s most successful investors. At first glance, their respective opinions seem to be diametrically opposed, but that is only true if you don’t understand how the stock market works.

In Let’s Get Fiscal, Krugman assesses the outlook for the economy saying that there is “grim news coming in about the real economy.” Summing up the economic situation, he states,

Just this week, we learned that retail sales have fallen off a cliff, and so has industrial production. Unemployment claims are at steep-recession levels, and the Philadelphia Fed’s manufacturing index is falling at the fastest pace in almost 20 years. All signs point to an economic slump that will be nasty, brutish — and long.

Krugman predicts that the unemployment rate, which is already above 6 percent, “will go above 7 percent, and quite possibly above 8 percent, making this the worst recession in a quarter-century.”

“And how long will it last? It could be very long indeed.”

Upon reading that, it would be understandable if you decide to sell all of your stocks and put the money from the proceeds “under the mattress,” so to speak. If you’re at all in agreement with Krugman’s analysis, you might want to buy “safe” CDs or, if you are totally freaked out, short-term U.S. Treasury securities, that are paying very close to zero interest.

That understandable inclination of reacting to bad current news, and worse predictions of the future, though perfectly natural, would likely also be entirely wrong. The reason is that the stock market looks forward. What is already known is “priced in the market.” Stock prices have already fallen in anticipation of a worsening economy. If and when the economy declines further, that will only confirm what we think we know now, so stock prices may not decline any more from where they currently stand.

In other words, as an investor, you cannot read the news or even someone’s prediction on where the economy is going and “profitably” act on it. In the stock market, “what everyone knows is not worth knowing.”

Please note, that nowhere does Krugman give any advice on what to do as an investor. That’s not his area of expertise. I am only projecting what a knowledgeable layman might conclude from reading Krugman’s observations.

That brings me to Warren Buffett’s opinion piece. It is an understatement to say that Buffett is a very, very, successful long-term investor. He’s been called, among other things, the Oracle of Omaha and the world’s greatest stock market investor, and an empire builder. His favorite holding period is “forever.” He certainly does not try to time the market, as he believes no one can do that successfully. (There is a lot of academic evidence that people who do try to time the market end up with terrible results.)

In Buffett’s Buy American. I Am, he agrees with Krugman’s basic thesis on the economy.

The financial world is a mess, both in the United States and abroad. Its problems, moreover, have been leaking into the general economy, and the leaks are now turning into a gusher. In the near term, unemployment will rise, business activity will falter and headlines will continue to be scary.

But here is the seeming paradox. What is Buffett doing?

I’ve been buying American stocks. This is my personal account I’m talking about, in which I previously owned nothing but United States government bonds. (This description leaves aside my Berkshire Hathaway holdings, which are all committed to philanthropy.) If prices keep looking attractive, my non-Berkshire net worth will soon be 100 percent in United States equities.

Why?

A simple rule dictates my buying: Be fearful when others are greedy, and be greedy when others are fearful. And most certainly, fear is now widespread, gripping even seasoned investors.

Since no one can forecast the short term direction of the stock market, Buffet continues:

Let me be clear on one point: I can’t predict the short-term movements of the stock market. I haven’t the faintest idea as to whether stocks will be higher or lower a month — or a year — from now. What is likely, however, is that the market will move higher, perhaps substantially so, well before either sentiment or the economy turns up. So if you wait for the robins, spring will be over.

This is typical Buffett — folksy, but right on. He then writes about the Great Depression and World War II, and notes that buying when things look bleakest was the right strategy. He concludes that “bad news is an investor’s best friend. It lets you buy a slice of America’s future at a marked-down price.”

Over the long term, the stock market news will be good. In the 20th century, the United States endured two world wars and other traumatic and expensive military conflicts; the Depression; a dozen or so recessions and financial panics; oil shocks; a flu epidemic; and the resignation of a disgraced president. Yet the Dow rose from 66 to 11,497.

You might think it would have been impossible for an investor to lose money during a century marked by such an extraordinary gain. But some investors did. The hapless ones bought stocks only when they felt comfort in doing so and then proceeded to sell when the headlines made them queasy.

Today people who hold cash equivalents feel comfortable. They shouldn’t. They have opted for a terrible long-term asset, one that pays virtually nothing and is certain to depreciate in value. Indeed, the policies that government will follow in its efforts to alleviate the current crisis will probably prove inflationary and therefore accelerate declines in the real value of cash accounts.

Equities will almost certainly outperform cash over the next decade, probably by a substantial degree. Those investors who cling now to cash are betting they can efficiently time their move away from it later.

This is my fourth post in the series called Is It Different This Time?  Feel free to read the others, especially if you are ready to hit the panic button and sell your stocks and/or stock mutual funds.

photo credit: notsogoodphotography